Nasurdin, being something of a mischievous sage, stole the man's remaining belongings and ran away down the road. A mile ahead, Nasurdin placed the bag he had just stolen in the middle of the road and hid in the bushes.
Some time later the destitute man whom Nasurdin had robbed came upon his bag and started jumping up and down for joy. Nasurdin, watching from the bushes, shook his head and said, "What it takes to make some people happy!"
The poor man went from being depressed to being overjoyed without any real change in his status; only his perception changed. The subprime meltdown is similarly more about perceived loss and gain than it is about tragedy. Perception is a far more powerful factor in framing the subprime meltdown than the absolute amount of loss and gain.
Nobel Prize winners Danny Kahneman and Amos Tversky noted this effect in their work in the '70s and '80s. They performed a series of experiments to examine how people perceive risk. In one such experiment they first gave people money and then asked them to bet half of it. What they found was that if someone were given $20 and subsequently lost $10, they perceived the transaction as a loss. But if someone was given no money to start with but subsequently won a $10 bet, that person perceived a gain. Of course, the net result in both cases was that the subject had $10 more than when they started, yet they had completely different perceptions.
How people frame a risk drives their risk decisions far more than do the facts. This is largely what is happening with the events occurring in the subprime mortgage market. Over the past several years, the housing market has been on a steady upward trend. The market as a whole in fact has been generating huge gains. While it was rising, investment houses were taking big risks and making big profits. A few years ago, Goldman Sachs was being lauded for its strong risk-taking culture to which was attributed the multibillion-dollar profits that it were making.
The folks on Wall Street are no fools. They know that risk and reward are inexorably linked. Taking risks means that there will inevitably be losses. The trick is to gain more than one loses. That is called turning a profit. For years they reveled in the record profits created by taking those big risks. But now after making hundreds of billions, they are losing tens of billions and they have forgotten the risk/reward equation.
It is somehow unsettling that our mental machinery can trick us into perceiving a loss when we are actually winning. Kahneman and Tversky documented hundreds if not thousands of ways in which human perception diverges wildly from logic when risk is involved.
In making decisions regarding the future of an organization, risk appetite has a huge influence on the company's fortunes. Being overly risk averse when one should be taking risks leads to underperformance and missed opportunity. Being overly risk taking when one should be more averse leads to huge losses. When perception overrides logic and fact, catastrophe is likely to follow. In spite of all of the profits earned, it looks like we will ensure disaster by becoming irrationally risk averse. What it takes to make some people happy!
BEAUMONT VANCE is the risk management columnist for Risk & Insurance®. He manages risk for Sun Microsystems Inc.
TOP 5 MOST READ SEPTEMBER STORIES:
1. Innovation: The Tortoise and the Hare
2. Rousmaniere: The 'IT' Thing in Comp
3. Innovation: Shackled Souls
4. A Firestorm of Lawsuits Over Global Warming
5. Innovation: Gaining Acceptance
October 1, 2007
Copyright 2007© LRP Publications